Estimation and Hedging with a One-Factor Heath-Jarrow-Morton Model

Abstract

“Term structure models can be broadly classified into equilibrium models, which posit a fairly simple form for the interest rate process but are typically not consistent with empirically observed market yield curves, and no-arbitrage models, which build in the constraint that the interest rate process embeds the current market term structure, but become mathematically more complex. Among no-arbitrage models, the Heath-Jarrow-Morton (HJM) model permits a very rich structure of rates and rate dynamics, but can become very complicated when it is adjusted for the current yield curve. In this article, Ho, Cadle, and Theobald offer two versions of a single-factor HJM model that can be fitted to market yields relatively easily. To illustrate the application of their approach, they present an historical simulation and analyze three different hedging techniques based on their model.”